India’s external sector is poised to take a ‘U’ turn — from an optimistic and sustainable Current Account Deficit (CAD) financed by normal capital flows to what may well be unsustainable levels of CAD and inadequate capital flows, resulting in a deficit in the overall balance of payment (BoP) position.

The pressure on the rupee and the depletion of foreign exchange reserves will add fuel to the fire. The reasons for such developments include the protracted war in Europe, net capital outflows, particularly foreign portfolio investment in the event of higher interest rates in the US and the strengthening of the US dollar, and an unprecedented increase in crude oil prices.

The data released recently are (a) Trade data released on July 4 and BoP data released on June 22; external debt and the International Investment position (on June 30) disseminated by the RBI; (b) the level and volatility of rupee depreciation and the intervention of the RBI; (c) the position of foreign exchange reserves, and (d) possible policy initiatives by the authorities.

Trade data for April-June 2022 showed a trade deficit of $70.25 billion with a 22.22 per cent increase in exports and a 47.31 per cent rise in imports. Crude oil imports accounting for 32.12 per cent zoomed 94.34 per cent.

The BoP data for 2021-22 recorded CAD at $38.9 billion (or 1.2 per cent of GDP) and with the net capital inflows of $86.3 billion, there was an accretion of $7.5 billion to forex reserves.

Based on the trends in April-June trade data and trends in services, income (primary and secondary) and net capital flows, BoP arithmetic for 2022-23 shows the following: Exports (15.2 per cent of GDP as against 13.2 per cent in fiscal 2021-22); Imports (22.7 per cent of GDP as against 19.2 per cent in 2021-22), oil imports (6.8 per cent of GDP as against 5 per cent in 2021-22); trade deficit (7.5 per cent of GDP as against 5.9 per cent in 2021-22).

Going by the trend of 2021-22, net services is estimated at 3.2 per cent of GDP and net income at 1.1 per cent of GDP. Given these numbers, the CAD for 2022-23 is estimated at 3.2 per cent of GDP.

In nominal terms, this will be around $110 billion. This estimate assumes net capital flows of $80 billion, a shade lower than that of $86.3 billion in 2021-22 because of higher net outflows in FPI and lower FDI inflows due to uncertainty in the global markets.

This indicates an overall BoP deficit of around $30 billion, which is a record in recent years. The last such high level of deficit in overall positions of BoP was recorded in 2008-09, but that too was lower at $20 billion in the aftermath of the global financial crisis. This tells us the severity of the crisis we are heading into.

The implications

First, CAD at 3.2 per cent of GDP is not sustainable. This is corroborated by the empirical work by RBI published in the Report on Currency and Finance, April 2022. According to the report, growth begins to decelerate with a CAD-GDP ratio beyond 2.3 per cent.

Second, the deficit in the overall BoP position of $30 billion translates to sale of US dollars by the RBI to the tune of $30 billion. The forex reserve position as per RBI data stood at $593.3 billion as on June 24, of which $529.2 billion accounted for foreign currency assets. It may be noted that over March 2022, these assets have declined by $11.5 billion and on Y-o-Y the decline of assets was of the order of around $37 billion. Assuming a further decline of $30 billion of reserves as explained above at the end March 2023, the foreign currency assets position will be around $500 billion.

Third, the estimated decline in reserves is pertinent from the angle of RBI intervention in forex market to arrest the rupee’s decline.

So far, the rupee has depreciated by 3.93 per cent (March-end over June-end), as compared with higher levels of depreciation in Argentina (10.2 per cent), Brazil (10.9 per cent), China (5.3 per cent), Malaysia (4.4 per cent), the Philippines (6.0 per cent), Thailand (5.2 per cent), Turkey (13.3 per cent) and South Africa (9.4 per cent).

The exchange rate is determined by demand and supply and with a deficit in the overall BoP position, the pressure on the rupee increases. The moot question therefore is: should the RBI intervene in the forex market to arrest the decline and/or volatility in the rupee?

Volatility vs depreciation

The RBI Currency and Finance report of April 2022 observed that it is the volatility of the exchange rate that impacts exports more than the level of exchange rate. The study further mentioned that a 10 per cent increase in the average exchange rate volatility decreases export earnings by 1.6 per cent.

With regard to profit, the study observed that a 10 per cent increase in volatility decreases profits by 3 per cent, while a 10 per cent depreciation of the NR against the US dollar, decreases profits by 21 per cent.

According to the RBI, this may be explained by the fact that exchange rates movements may affect the cost of borrowings for firms holding foreign debt.

Furthermore, estimation results indicate that the depreciation of exchange rates increases the interest payments on foreign loans although volatility has no significant effect. Thus, the level and volatility of rupee depreciation is important for exporting firms.

Two other important aspects are external debt and the international investment position (IIP).

India’s external debt revealed that the short-term debt on residual maturity (debt obligations that include long term debt by original maturity falling due over the next 12 months and short-term debt by original maturity) constituted 43.1 per cent of total external debt and 44.1 per cent of foreign exchange reserves.

This ratio will further increase given the depletion of forex reserves by $30 billion as alluded to earlier. The IIP position showed that foreign debt liabilities accounted for 49.2 per cent.

So the external sector faces a grim situation. We need policies to to enhance export competitiveness and ease processes to encourage FDI inflows. RBI’s action on July 6, to attract: (a) NRI deposits (exemption from CRR and SLR and relaxation of ceiling on interest rates), (b) ECBs (increase of limit to $1.5 billion from $750 million) and (c) FPI investment in debt (relaxation of the limit of 30 per cent) are short-term fixes that will only postpone the problem.

These will result in fuelling external debt and bringing pressure on repayment and eventually on currency movement.

The writer is a former central banker and a faculty member at SPJIMR. Views expressed are personal (Through The Billion Press)